Island Investing: The Ole P&L

Q. What do I need to know about a company’s income statement before I invest?

A. In short – as much as you can stand. A balance sheet contains items that usually don’t merit spending hours on. However, an income statement, also called a profit and loss statement or “P&L”, is a different story. You should try to learn everything you can about a company’s income statement to really understand how the company makes money.

You’ll recall that a balance sheet is a snapshot in time, telling us how well a company is managing its resources. The income statement, together with the cash flow statement I’ll discuss next week, forms more of a moving picture that tells us how well a business is managing its operations.

The term “earnings” on the income statement is synonymous with profit, and it’s hard to argue that you should invest in a business for any other reason than because of attractive, growing profits. Because of that, earnings are the most widely scrutinized financial metric that companies report. Management has some latitude when applying accounting principles in the income statement, so assessing the quality of those earnings is an important ability for a stock investor to learn.

There are no shortcuts to learning how to analyze an income statement. It can take some time, but I’ll soon publish a list of recommended books to help you start to learn as quickly as possible. It’s important to keep the big picture in mind, though, as per this quote from Warren Buffett, “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

If I had two tips for investors regarding income statements, the first is to be wary of investing in companies with pension plans. Pension accounting can be the greatest form of earnings manipulation known to man. The second tip would be, “Profit is an opinion, but cash is a fact.” Next week I’ll talk more about cash flows.